Global banking regulators are considering new measures that would make it harder for banks to understate the riskiness of their assets. The BIS decision, as WSJ reports, to end the long-standing treatment of all government bonds as automatically risk-free, is clearly being priced into European banking stocks (as we noted here). Since the financial crisis European banks have backed up the truck on their domestic sovereign bond issuance (most especially Italy and Spain) - draining every fund to buy over EUR1.8 trillion of these 'risk-free' assets. However, that party is potentially ending as The Basel Committee panel is looking at barring banks from assigning very low risk levels to certain types of assets, a tactic some lenders have used to reduce their capital requirements; which could force banks to raise billions of dollars in extra capital.

Aided in part by generous regulatory treatment, European banks are among the biggest buyers of their governments' bonds.

As of May, euro-zone banks were holding €1.8 trillion of such debt, accounting for nearly 6% of their total assets, according to European Central Bank data. Those holdings have been treated as risk-free for capital purposes because of the historically low odds of a government default—an assumption that was badly shaken during the continent's recent crisis.

But things are about to change...

Global banking regulators are considering new measures that would make it harder for banks to understate the riskiness of their assets, including potentially ending the long-standing treatment of all government bonds as automatically risk-free, according to people familiar with the discussions.

The changes under consideration by the Basel Committee on Banking Supervision, the Switzerland-based group that sets global banking rules, could force banks to raise billions of dollars in extra capital.

The Basel Committee is considering new regulations that would reduce banks' latitude to measure the riskiness of their own assets, a key determinant of how much capital they need to hold, these people said. The panel is looking at barring banks from assigning very low risk levels to certain types of assets, a tactic some lenders have used to reduce their capital requirements, these people said.

It appears the Basel committee is discussing 2 alternatives...

1) the possibility of changing the zero-risk policy and instead requiring banks to evaluate their sovereign risks in the same manner as other assets; or

2) risk-weighting "floors," which would set minimum risk weights for certain classes of assets, according to people familiar with the discussions. That could be included in a package of proposals in November, they said.

The prospect of both changes already is attracting industry protests.

Introducing risk-weighting floors "would have the effect of increasing capital requirements for banks," said Thomas Huertas, a former top British regulator and now a partner at consultancy EY.

Bank executives and some Basel Committee members worry that the existence of floors could prompt banks to shun low-risk loans if they can't treat them as essentially risk-free.

In Italy, where banks are big holders of government debt, industry executives have warned the central bank that it would become less desirable for them to buy such bonds if they didn't enjoy the risk-free status, according to a person involved in the discussions. That likely would translate into higher borrowing costs for the Italian government, the bankers warned.

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